Fed Prep: Big Money Piling Into Bank ETFs

The Federal Reserve's final meeting of 2016 kicks off Tuesday, and many market observers believe an interest rate hike of at least 25 basis points is a sure thing. With that in mind, investors are heading to some predictable destinations in the exchange-traded funds landscape.

Trend Plays Out

Predictably, that trend includes the Financial Select Sector SPDR Fund XLF, the largest financial services ETF. Thanks in part to the election of Donald Trump as the 45th president of the United States and in anticipation of higher interest rates, XLF is higher by 2.6 over the past week and nearly nine percent over the past month.

The Fed is almost universally viewed as one of the most determinants of performance for ETFs such as XLF and the SPDR KBW Regional Banking (ETF) KRE, but the central bank appears unlikely to oblige, as bonds markets are pricing in diminishing odds of even one rate hike before the end of this year. That deals a blow to a sector and its ETFs that came into 2016 with hopes of up to four rate hikes.

Regional bank funds like KRE are seen as prime beneficiaries of higher interest rates. Simply put, net interest margins at regional banks have been suppressed by the Fed's zero interest rate policy and reversing that policy is seen as an important catalyst in boosting profits for the banks in ETFs such as KRE.

“We point out the insatiable desire for upside in the largest Financial Equity based ETF, XLF (SPDR Financial) via 6 percent out-of-the-money January 25 calls in the product,” said Street One Financial Vice President Paul Weisbruch in a note out Monday. “In what is likely related activity, there has been more than $600 million created in the fund in the marketplace in recent sessions as well, adding to the more than $2.6 billion that has entered the ETF year-to-date.”

Leveraged Financials

Still, some traders are preparing for the Fed to disappoint. For example, the Direxion Daily Financial Bear 3X Shares FAZ has averaged daily inflows of over $1.8 million over the past month, according to Direxion data.

FAZ attempts to deliver triple the daily returns of the Russell 1000 Financial Services Index. That is not the same index tracked by XLF.

Leveraged ETFs, such as FAZ “pursue daily leveraged investment objectives which means they are riskier than alternatives which do not use leverage. They seek daily goals and should not be expected to track the underlying index over periods longer than one day,” according to Direxion.